Stocks' ratings shape Schwab's Hedged Equity

Schwab Hedged Equity Fund's Vivienne Hsu bets on, and against, stocks according to ratings her firm assigns. Otherwise, she might not own Payless ShoeSource, the fund's second-largest holding.

Payless, which operates about 4,600 shoe stores, amounted to 3.4 percent of Hedged Equity's assets as of Jan. 31. Charles Schwab Corp. gives the stock its highest rating of A, equivalent to "strongly outperform," under a system relying on criteria such as price-to-earnings ratios and cash flow.

"The last two pairs of Payless shoes I owned left my feet bleeding," said Hsu, 37. "I wouldn't recommend the stock based on my experience, but it's got a lot of good things going for it when you get down to it."

Hsu beat the Standard & Poor's 500 index during her two years at the $559 million mutual fund by relying on the ratings.

In the past year, the fund ranked fourth of 24 U.S.-based mutual funds that can bet on lower share prices and have at least $100 million in assets, according to data compiled by Bloomberg.

Schwab, the largest U.S. discount brokerage firm, started the A-to-F grading system in response to Wall Street investment banks' $1.4 billion settlement in 2002 of cases tied to tainted research.

Hedged Equity tests the San Francisco company's "fact-based" system, Schwab Equity Ratings, and Hsu's ability to pick from among the 3,000 U.S. companies covered.

"For an investor, it's a leap of faith that these ratings are accurate and predictive," said Jeff Tjornehoj, a research analyst at fund-research firm Lipper in Denver.

Hedged Equity, co-managed by Jeffrey Mortimer and Larry Mano, returned 11 percent last year. That's more than twice the 4.9 percent return on the S&P 500.

The fund also beat the index in 2004, when Hsu replaced Robin Jackson, a former hedge-fund manager. Jackson trailed the S&P 500 in 2003, the fund's first full calendar year.

Unlike most funds, Hedged Equity gives Hsu the chance to profit from both rising and falling stock prices like hedge funds, which are designed for wealthier investors.

About 25 percent of Hedged Equity's 200 holdings are "short sales," or sales of borrowed shares in anticipation that the stock price will decline. They include MGI Pharma, a drug maker rated F, or "strongly underperform." The rest are stakes in companies including Payless and McKesson, the fund's largest investment.

"It's kind of a hedge fund for everyone else," Hsu said. "But unlike a hedge fund, our fund is so diversified that it hedges risk."

Hedged Equity's objective is to beat the S&P 500 with only half the risk associated with the index. Investors pay an annual management fee amounting to 2 percent of assets, above the 1.18 percent for similarly managed funds, according to Schwab's Web site. The minimum investment is $2,500.

Hedge funds, by contrast, typically take 20 percent of investment gains along with a 2 percent management fee. A minimum $1 million investment is often required.